Dominant Currency Paradigm: A New Model for Small Open Economies

Author/Editor:

Camila Casas ; Federico J Diez ; Gita Gopinath ; Pierre-Olivier Gourinchas

Publication Date:

November 22, 2017

Electronic Access:

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Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary:

Most trade is invoiced in very few currencies. Despite this, the Mundell-Fleming benchmark and its variants focus on pricing in the producer’s currency or in local currency. We model instead a ‘dominant currency paradigm’ for small open economies characterized by three features: pricing in a dominant currency; pricing complementarities, and imported input use in production. Under this paradigm: (a) the terms-of-trade is stable; (b) dominant currency exchange rate pass-through into export and import prices is high regardless of destination or origin of goods; (c) exchange rate pass-through of non-dominant currencies is small; (d) expenditure switching occurs mostly via imports, driven by the dollar exchange rate while exports respond weakly, if at all; (e) strengthening of the dominant currency relative to non-dominant ones can negatively impact global trade; (f) optimal monetary policy targets deviations from the law of one price arising from dominant currency fluctuations, in addition to the inflation and output gap. Using data from Colombia we document strong support for the dominant currency paradigm.

Series:

Working Paper No. 17/264

Subject:

English

Publication Date:

November 22, 2017

ISBN/ISSN:

9781484330173/1018-5941

Stock No:

WPIEA2017264

Price:

$18.00 (Academic Rate:$18.00)

Format:

Paper

Pages:

62

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